How to Sell Your Business, page 6

Understanding Valuation, continued

The other issue is the discount rate to use with the earnings stream. (Clearly, earnings to be received in the future are worth less than those received today, but how much less?)

With publicly traded companies, the price earnings (“PE”) ratio roughly expresses this valuation concept on a per share basis. In other words, the PE is the multiplier on the current earnings that expresses both the (uncertain) value of future earnings, and the present discount rate.

A starting place in determining your own valuation is the look at the average PE for the S&P500 (currently in the mid twenties). Another rule of thumb is that a PE can be as high as the business’s growth rate.

However, a private business should not be valued as high as the S&P500 companies, which are the best run, most consistent, and financially transparent in the world. Also, public company PEs are calculated on an after tax basis, and private businesses are generally valued pre-tax.

This all boils down to a general range of private business valuations between three and five times annual free cash flow (EBIDTA).

In a private business, many items are taken as business expenses that are really a form of owner compensation. (One notorious practitioner of this being Leona Helmsly, but all small business owners do it to some degree or other. This “tax advantage” is one reason many people become small business owners.) Common items treated this way include cars leased for family members and compensation paid to family members for doing nothing.

To accurately calculate free cash flow or earnings, these items need to be removed as business expenses (generating statements that show these adjustments is sometimes called “recasting”).

In other words, preparing the statements that justify a valuation is a non-trivial exercise. Additionally, it’s important to explicitly state all assumptions used to justify a valuation, and to critically assess all assumptions for consistency, common sense, and logic. The buyer certainly will.

Revenue can also be used as a basis for valuation. While any amount of revenue says nothing about earnings, revenues cannot be manipulated through accounting wizardry as easily as earnings. Generally, when purchases are made on the basis of revenue, the reasoning is that management changes will cut down on expenses, leading to profitability. When revenue is used, the range for valuation is usually between 0.7 and one times annual sales.

Often, specific industries have specific rules of thumb regarding valuation. Interviewing intermediaries with specific industry expertise is the best way to determine these rules of thumb (see Working with Intermediaries later in this article), which can be used in much the way comparables regarding homes in the same neighborhood are used in real estate sales.

Continued next page

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